Q#3. The M& M capital structure theory in chapter 15 persuasively argues that th
ID: 2629948 • Letter: Q
Question
Q#3. The M& M capital structure theory in chapter 15 persuasively argues that the optimal debt is not a 0.0 % debt to equity ratio (i.e., firms should use some debt). The chapter 15 shows that, consistent with M&M theories, the average long-run debt to equity ratio in many different industries ranges from 23% to 177%. Yet some technology firms, such as Microsoft, google, and Apple, do not use any long-term debt or almost 0.0% long-term debt. Please explain whether it makes financial sense for such firms to use no debt. You would want to use your understanding of capital structure material in chapter 15, especially signaling and asymmetric information theories, in your answers. Limit your answers to no more than ten (10) sentences.
Textbook: Financial Management: Theory and Practice, by Brigham and Ehrhardt 14th Ed.
Explanation / Answer
Technology firms have historically tended to not use debt because their revenue streams tended to be very volatile and they did not want to take the risks of being unable to service their debt (and hence face bankruptcy) in periods of large downturns. When a technology company gets to the size of an Apple, Google, Microsoft, there is no reason not to use some debt to leverage earnings, as the chances of business getting so bad that they can't serivice any debt is highly unlikely. However, tradition carries on. This is why you tend to see technology companies accumulate large cash balances, ie to protect against a period of prolonged and severe business downturn.
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